Question

Ryan plans to open a pizza shop in College town Alabama this fall. The cost of this project will be $325,000. She expects to generate operating cash flows of $67,000 for the first 7 years, after which she will decided whether to quit or continue to operate. If her cost of capital is 13%, what is the project’s profitability index? Is the project acceptable?

Answer 1

Initial Investment = $325,000
Annual OCF = $67,000
Life of Project = 7 years
Cost of Capital = 13%

Present Value of Cash Inflows = $67,000/1.13 + $67,000/1.13^2 + … + $67,000/1.13^6 + $67,000/1.13^7
Present Value of Cash Inflows = $67,000 * (1 - (1/1.13)^7) / 0.13
Present Value of Cash Inflows = $67,000 * 4.422610
Present Value of Cash Inflows = $296,314.87

Profitability Index = Present Value of Cash Inflows / Initial Investment
Profitability Index = $296,314.87 / $325,000
Profitability Index = 0.91

Ryan should not accept this project as its Profitability Index is less than 1.00